University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
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348

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28
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sonalhava9qv

Supply-Side Equilibrium: Unemployment and Inflation? Contents ● Aggregate Supply Curve ● Equilibrium of AD and AS ● Inflation and the Multiplier ● Recessionary and Inflationary Gaps Revisited ● Adjusting to a Recessionary Gap or an Inflationary Gap ● Stagflation from an Adverse Supply Shock The Aggregate Supply Curve ● Like AD, AS is a curve and not a fixed number. ● Qs by firms depends on prices, wages, other input costs, and technology. ● AS represents the relationship between P level and GDP supplied, holding all other determinants of Qs fixed. ● AS has a (+) slope → ↑P → ↑Qs ● Firms are motivated by profit. ♦ Profit per unit = P – AC FIGURE 1. An Aggregate Supply Curve Price Level S S Real GDP Why does the Aggregate Supply Curve have a Positive Slope? ● Many input prices are fixed for certain periods of time. ♦ Long-term contracts for L or raw materials ● Firms choose Qs by comparing selling prices with production costs which depend on input prices. ♦ If ↑selling prices while input costs are fixed → ↑Qs ♦ If ↓selling prices while input costs are fixed → ↓Qs Shifts of the Aggregate Supply Curve ● Costs of production are constant along the AS curve. ● ∆ costs of production ⇒ shifts AS curve 1. Money wage rate ● wages account for more than 70% of all prod costs. ♦ ↑wages → ↓profit at any given P of output → ↓Qs ♦ ↑wages → shifts AS inward and ↓wages → shifts AS outward 2. Prices of other inputs ♦ ↑P of any input → shifts AS inward and ↓P of any input → shifts AS outward Shifts of the Aggregate Supply Curve 3. Technology and productivity ● Technological breakthrough that ↑L productivity → ↑output per hour of L → ↑profit per unit → ↑Qs ● Technological improvements shift AS outward 4. Available supplies of labor and capital ● AS curve shifts out if L force↑; ↑L quality; or ↑K stock because more output can be produced at any given P level. FIGURE 2. A Shift of the Aggregate Supply Curve S1 (higher wages) S0 (lower wages) B Price Level 100 S1 A S0 5,500 6,000 Real GDP Equilibrium of Aggregate Demand and Supply ● Intersection of AD and AS determine the equilibrium level of real GDP and the P level. ● Equilibrium (in Fig 3) occurs at a P level = 100 and GDP = $6,000B. ♦ At higher P levels, like 120, Qs > Qd by $800B → ↑inventories → ↓prices and ↓output. ♦ At lower P levels, like 80, Qd > Qs by $800B → ↓inventories → ↑prices and ↑output. FIGURE 3. Equilibrium Real GDP and the Price Level S Price Level D 130 120 110 100 90 80 E S D 5,200 5,600 6,000 6,400 6,800 Real GDP Inflation and the Multiplier ● Recall: multiplier effect suggests A’s spending becomes B’s income, and B’s spending becomes C’s income, etc. ● Earlier discussion focused on spending and assumed the P level was fixed. ♦ Focused on the D-side equilibrium and ignored the reactions of firms (i.e., the S-side). ● Will firms supply the additional demand without ↑P? ♦ Not if AS slopes upward! ● Inflation ⇒ ↓ size of the multiplier Inflation and the Multiplier ● In Fig 4, ↑I by $200B which shifts AD out by $800B ($200B x oversimplified multiplier of 4). ♦ Shown by the movement from E0 to A. ● Firms react to higher levels of spending (shift of AD at P level = 100) by ↑output and ↑prices. ♦ Shown by the movement from E0 to E1 –along AS curve. ● ↑P level → ↓purchasing power of money-fixed assets → ↓C and ↓X-IM ♦ Shown by the movement from A to E1 –along new AD curve. ● Multiplier is only 2 now = ∆Y/∆I = $400B/ $200B. FIGURE 4. Inflation and the Multiplier Assume I rises by $200B. This raises total expenditure (or Q of AD) by $800 (= $200B x multiplier of 4). D1 Price Level (Y) D0 130 120 110 100 90 80 If AS were horizontal → multiplier = 4 and equil GDP would rise to $6,800B. S $800 billion E1 E0 D1 D0 S 6,000 Real GDP (Y) NOTE: Amounts are in billions of dollars per year. 6,400 6,800 If AS were vertical → multiplier = 0 and equil GDP would remain at $6,000B. Here AS is upward sloping and ↑P level with the shift in AD. The multiplier is 2 (= $400B/$200B). Recessionary and Inflationary Gaps Revisited ● Short run: equilibrium of AS and AD may or may not equal full employment GDP ♦ Recessionary gap: equilibrium GDP < full employment or potential GDP ♦ Inflationary gap: equilibrium GDP > full employment or potential GDP ● Long run: wages adjust to labor market conditions to make equilibrium GDP = full employment or potential GDP ♦ But this may take a long time! Adjusting to a Recessionary Gap ● In Fig. 5, equil GDP falls below the full employment level. ● This might be caused by weak C or low I. ● Loose L market ♦ There is UE and jobs are hard to find. ♦ Employees may be anxious to keep their jobs. ♦ Workers won’t win ↑wage and wages might fall. ● If ↓wages → AS shifts outward →↓P level and ↓UE ● Deflation erodes the recessionary gap –but this process happens very slowly! FIGURE 5. The Elimination of a Recessionary Gap Recessionary gap = $1,000B. Potential GDP S0 Price Level S1 Weak spending and UE at pt E. Weak labor markets put pressure on wages to fall. D E 100 B F S0 Recessionary gap D S1 6,000 7,000 Real GDP Falling wages shift AS outward which lowers prices. Falling prices stimulate C and net X. Adjusting to a Recessionary Gap ● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-WWII period. ● E.g., even with the severe recession of 1981-82 where UE reached 10%, prices and wages were not forced down –though their rates of increase were. Adjusting to a Recessionary Gap ● Why haven’t wages fallen much since WWII? ● Institutional factors: like min wages, union contracts, and gov regulations that place legal floors on wages and prices. These were all developed since WWII. ● Psychological resistance: firms are reluctant to cut wages for fear their employees will resent it and reduce effort. ♦ But why wasn’t this true prior to WWII? Adjusting to a Recessionary Gap ● Business cycles were less severe: after WWII so firms and workers wait out the bad times rather than accept wage or price cuts. ● Firms lose their best workers: if a firm cuts wages, it may lose its best employees. Individual productivity is hard to measure. The best workers have the greatest opportunities elsewhere. ♦ Should have been true before WWII. ● With sticky wages and prices, cyclical unemployment may last a long time. Adjusting to a Recessionary Gap ● Does the Economy Have a Self-Correcting Mechanism? ♦ The economy will self-adjust eventually. ■↓ wages ⇒ ↑ demand for labor ■↓ prices ⇒ ↑ demand for goods and services ♦ But many people believe that gov intervention should help to speed up the process. ● Eg., Recovery from 1990-91 recession took almost 4 years. ♦ UE fell from 7.7% to 5.4% ♦ Inflation fell from 6.1% to 2.7% Adjusting to a Recessionary Gap ● An Example from Recent History: Disinflation in Japan in the 1990s. ♦ Recovery from the 1990-91 recession was weak and long delayed, but it did eventually come. ♦ Practical question: How long can we afford to wait? Adjusting to an Inflationary Gap ● When spending is strong, equil GDP > full employment GDP. ● Labor markets are tight. ♦ Jobs are plentiful and L is in demand. ♦ Firms will have trouble filling vacant positions and may offer higher wages to lure workers away from their current jobs. ● ↑wages → shifts AS inward →↓output and ↑prices ● Inflation occurs because buyers are demanding more than the economy is capable of producing at normal operating rates. Adjusting to an Inflationary Gap ● In Fig. 6, AS shifts inward → ↑P level → ↓purchasing power of consumer wealth →↓C and ↓X-IM. ♦ Shown by the movement from E to F along AD curve. ● Stagflation occurs in the movement from E to F as ↓GDP and ↑P level. ● This process takes time because wages and prices adjust slowly! FIGURE 6. The Elimination of an Inflationary Gap Potential GDP S1 D Price Level S0 F B E S1 Inflationary gap S0 Real GDP D Adjusting to an Inflationary Gap ● Demand Inflation and Stagflation ● Inflationary gap is caused by high levels of spending. ♦ High demand for goods pushes prices and wages higher. ♦ Often hear business managers and journalists claim that ↑wages are causing inflation. ♦ Yet, ↑wages are a symptom not the cause of inflation. ● Stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP. Adjusting to an Inflationary Gap ● U.S. economy experienced an episode of stagflation between 1988 and 1990. ♦ Economy reached UE rate of 5% (15 year low). ♦ Inflation rose from 4.4% to 6.1% to cure the inflationary gap. ♦ GDP growth rate fell from 3.5% in 1988 to -0.2% in 1990. Stagflation from an Adverse Supply Shock ● In 1973, OPEC x 4 the P of oil. ♦ ↑costs of production for U.S. firms ● In 1979-80, OPEC struck again but P of oil x 2. ● Same thing happened during 1990 Gulf War –but to a smaller extent. ● ↑P oil → inward shift of AS → ↓GDP and ↑P level. FIGURE 7. Stagflation from an Adverse Shift in AS Data from 1973 D In 1973, ↑P of oil x 4 → ↓real GDP by 1% and ↑P level by 19%. S1 Price Level S0 A 42.2 35.4 E S1 D S0 3,870 3,900 Real GDP

Supply-Side Equilibrium: Unemployment and Inflation?

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